DR.CHENJIAZI ZHONG

Macro Update

On U.S.

U.S. GDP growth was a bit more sluggish than expected in the second quarter as businesses aggressively ran down stocks of unsold goods, which offsets a spurt in consumer spending. U.S. consumption and employment situation remain strong. U.S. stocks continue to gain, fueled in part by the Federal Reserve staying put and concerns about the rest of the world. Further gains require significant improvement in earnings, but earnings do not justify the valuations. Investors should continue to exploit opportunities in dividend growers and quality stocks.

On Eurozone

Growth in the eurozone manufacturing sector lost momentum in August. The Markit Eurozone Manufacturing PMI final data came in at 51.7 in August 2016 from 52 in July, a three-month low. New orders inflows rose to the weakest extent in one-and-a-half years, companies posted slower increases in new business from domestic and export sources, production expanded slower, resulting in weak job creation.The European Central Bank stimulus is supportive, but post-Brexit uncertainty challenges already poor profits. Investors should be cautious on European banks.

On U.K.

A weak pound helps U.K. exporters. Investors should remain cautious on U.K. domestic stocks. At its August 4 meeting, the Monetary Policy Committee (MPC) of the Bank of England (BOE) sparked considerable excitement when it announced a program of monetary easing via a wide variety of measures. The sharp market moves that followed indicate that the consensus did not expect the MPC to deploy such a wide array of policy options. The BOE also forecasts the U.K. economy slowing to marginally positive growth rates and inflation rising to slightly above the 2% target.

On Japan

The government’s decision to make a significant investment has been made in light of Cool Japan Fund Inc. being established in 2013, and the hosting of 2020 Tokyo Olympic and Paralympic Games, and now may be the appropriate time to reconsider the public perception of Cool Japan. The Bank of Japan is nearing the limits of monetary policy and structural reforms are needed. Attractive valuations and better corporate governance are not enough to offset a soft economy and rising yen.

On China

PBOC started supplementing those 7-day repos with pricier 14-day repos, a move that decreases the amount of cheap, short-term credit available in the financial system and guides demand toward longer-term borrowing. Financial sector reform and rising current account surpluses are encouraging. China’s economic transition is ongoing, but the lower growth rates are priced in.

“China is on the verge of changing from an economy where prices keep dropping to one in which deflation is expected to dwindle to almost nothing. That is a dramatic departure from the past 50 months, when deflation dragged down not only prices in China but in most of the world, thanks to exports of ever cheaper manufactured goods, as well as falling commodity prices.”[1]

On Real Assets

Commodity markets are oversupplied. Oil fundamentals have improved but much of this is priced in. The strongest performing major asset class so far this year is gold, partially because 2016 has been marked by political turmoil, causing investors to seek safe-haven assets, and the delay of further interest rate hikes by the Fed. While inflation is expected to remain low for now, investing in natural resources has historically provided an effective hedge against inflation and deflation.

The Monetary Policy Committee’s Actions

The BOE’s MPC sets monetary policy to meet the 2% inflation target, and in a way that helps to sustain growth and employment. At its meeting ended August 3, 2016, the MPC voted for a package of measures designed to provide additional support to growth and to achieve a sustainable return of inflation to the target. This package comprises:

• Cut the policy rate by 25 basis points to 0.25%, and indicate that the MPC expects to ease further towards but remain above zero, at which point the MPC will cease further interest rate reductions.
• Restart the quantitative easing program by buying 60 billion pounds of nominal UK sovereign bonds over a six-month period, which equates to 120%[2] of gross nominal issuance.
• Restart term financing for UK banks via a four-year Term Funding Scheme with interest rates close to the policy rate.
• Initiate a corporate bond buying program by purchasing 10 billion pounds in sterling-denominated corporate bonds in the secondary market, out of an eligible universe of 150 billion pounds[3].

The Dynamics of Investment Spending

To analyze the dynamics of investment spending is critical in understanding economic growth and expected investment returns. Inefficient capital spending typically leads to weaker returns in certain markets, while capital discipline helps establish a foundation for profitability improvement. The recent softness in U.S. productivity suggests that the weakness in investment spending could be to blame:

1. It may be difficult to measure productivity from a capital base increasingly skewed toward intellectual property, and the productive outcomes from R&D could potentially take longer to come to fruition, temporarily depressing productivity.
2. The slow growth of capex elements has led to an aging capital stock, which may negatively affect productivity.
3. Sluggish rates of investment in equipment and structures could point to a lack of capital per unit of labor, further weakening productivity.

Investment Implications

Lower rates and a flatter yield curve certainly put pressure on banks’ profitability; however, the other policy measures, such as term financing operations and easing of capital requirements, were designed to cushion the potential reductions in profitability. The underlying commercial banking business of the UK banks are still highly profitable, and as such the new monetary policy measures should not seriously hamper the functioning of the banking system.

Natural resource equity performance historically has run somewhat counter to overall equity performance, so the sector can be a hedge against secular weak performance in overall global equities. Investing in natural resources has also provided an effective hedge against inflation and deflation. It makes sense to keep some allocation to natural resources for their diversification benefits. Gold continues to be a portfolio diversifier. , which is particularly important as we see volatility remaining high. Commodities in general have had a negative correlation with the dollar, providing currency diversification as well.

[1] Source: Financial Times, August, 15, 2016

[2] PIMCO calculations

[3] Source: Bank of England